Carol has been caught in the auto loan prepayment penalty trap. Back
when auto loans ran two or three years this wasn't a problem. But,
with the average auto loan approaching six years, more lenders have
included prepayment penalties. Especially for buyers with credit
problems and high interest loans.
Let's learn a little about prepayment penalties. Then we'll see what
choices Carol has and what the rest of us can do to avoid the trap
that Carol is in.
Unfortunately for consumers, there's more than one way to extract a
prepayment penalty from a borrower who wants to pay off an auto loan early.
The simplest method is to charge a percentage of the remaining loan
balance as a penalty. As the principal owed goes down, so does the
penalty. Prepayment penalties are allowed in 36 states and the
District of Columbia. The bad news for the lender is that it's easy
for a consumer to understand what's going on and 14 states don't
allow prepayment penalties.
So some lenders dusted off an old method of computing interest
commonly known as the rule of 78s. It front loads the interest
charges - i.e. the first payments go toward repaying all of the
interest that will be owed over the life of the loan. Only after that
will payments reduce the principal. Paying off the loan early won't
save you any money. In 1992 Congress outlawed this method for loans
longer than 61 months. But 43 states allow it for shorter loans.
Yet another way to penalize prepayments is found in something called
a 'pre-computed' loan. In that loan you agree to repay the total
amount of interest plus the principal no matter how quickly you repay
the loan. Again, it's not technically a penalty for prepaying, it's
just a different type of loan. But the results are the same.
So what can Carol do? The first thing is to pull out her loan
agreement and read the section on prepayments. Also check the section
that explains how interest is calculated. She needs to know what
provisions she's facing.
It sounds as if she has a 'pre-computed' or 'rule of 78s' loan. If
that's the case there's not much she can do with the loan. The best
choice is to simply make her payments on time and save the extra
money for the purchase of her next car.
If there's a prepayment penalty she can use an online calculator to
figure out how much interest she'd save by paying the loan early and
compare that to the amount of the penalty. She'll find a good one on
the Bankrate.com site at
The sad fact is that once you sign an auto loan agreement with one of
these provisions there's not much you can do. Occasionally a lender
will waive the prepayment clause. But not often. The only real option
is to take the money that would have gone for prepayments and save it
where it'll earn some interest.
The best way to fix this problem is to avoid it. Unless you have bad
credit you should be able to find a simple interest loan with no
prepayment penalty. A simple interest loan only charges interest on
the money that you owe each month. Shop around until you find one. Do
your loan shopping before you find a car. Remember that the loan the
dealer offers may not be the best one you qualify for.
Read the fine print before you sign any loan agreement. No matter how
uncomfortable it is sitting in those tiny dealer cubicles with the
salesperson looking on. It's important. That's where you'll find
things like the prepayment penalty. Even a knowledgeable person will
require a half hour to plough through the paperwork. If you're
uncomfortable ask the salesperson to leave. They can return after
Don't be afraid to ask questions. As we've seen there's more than one
way to penalize a borrower who wants to repay an expensive loan
early. Just because you scanned the contract and didn't see the word
'penalty' doesn't mean that there's not one. Ask what happens if you
prepay the loan. And, be sure you understand the answer.
As a borrower the best answer you'll hear is that it is a 'simple
interest' loan. That means you only pay interest on the amount of
principal that you still owe each month. If you prepay any of the
loan, the principal amount is reduced and interest owed is calculated
on the lower principal the following month.
Finally, if the language seems over your head, take a copy home and
ask someone who's familiar with legalese to study it before you sign
it. Better to risk losing the deal on the car (unlikely) than to sign
a loan agreement that keeps you trapped with high payments for six or
Gary Foreman is a former financial planner who currently edits
Dollar Stretcher.com website and newsletters. If you wish you had
more time or money visit The Dollar Stretcher.com site. You'll find
thousands of articles to help you stretch your day and your dollar!